Decoding Intangibles

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Hold the hosannas for Edmund Jenkins and the Financial Accounting Standards Board. Yes, the accounting world’s grandees may have bowed to political reality when they eased their stance on accounting for business combinations, but their new thinking about goodwill could make life difficult for corporate executives in other ways.

Since FASB first proposed doing away with the pooling-of- interests accounting method two years ago, it has been attacked by finance executives, corporate lobbyists, and congressional critics alike. Chairman Jenkins was messing with the New Economy–throwing cold water on the hottest M&A market in history. If forced to amortize goodwill (the excess of purchase price over the fair value of an acquired company’s assets), under the purchase method of accounting, acquisitive companies such as Cisco Systems, General Electric, and Medtronic would have to take billions of dollars of charges to earnings.

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By way of compromise, FASB’s new rules, issued in a February 14 exposure draft, allow goodwill to be recorded as a nonwasting asset on the balance sheet. Companies will not have to amortize the balance to earnings over a 20-year period, as FASB proposed in its 1999 exposure draft. Instead, they will periodically test the asset for impairment, and if it is determined that the value of a reporting unit with acquired goodwill has indeed been impaired, companies will be forced to take a write-down.

The problem is that those potential write-downs are likely to generate a lot more negative reaction in the market than simple, scheduled amortization charges. In addition, FASB’s proposal is certain to increase the pressure on companies to assess the value of their intangible assets, whether acquired or internally developed, and to report their findings to investors–if not in the form of balance-sheet itemization, then in footnotes or other supplemental disclosures.

The pressure for more disclosure is already significant. A growing number of academics, consultants, and regulators see the lack of information on intangible assets as a major deficiency in the GAAP regime. They argue that those assets increasingly drive the value of corporations, and yet currently receive next to no recognition in financial disclosures. “In the last 15 to 20 years, most of the value and performance of companies have come from intangible assets,” asserts New York University accounting and finance professor Baruch Lev, who has developed a method for valuing intangibles that has served as the basis for three CFO Knowledge Capital Scoreboards. “It’s distressing that other than research-and-development costs, there is no information provided on them.”

To rectify that deficiency, both the Securities and Exchange Commission and FASB have convened commissions to study the issue and propose ways to improve disclosure. And last year, the Brookings Institution organized a task force of around 50 people from various constituencies to examine how public policies influence the ways that corporations measure, monitor, and invest in intangible assets. In addition, consultants such as Bob Herz, who along with three other partners at Pricewaterhouse-Coopers published the book The Value- Reporting Revolution last month, are pushing companies to embrace better reporting practices for intangible assets. Why? “We think that to the extent that companies develop the metrics and communicate them to the market, they’ll get better stock valuations, because of the added transparency,” says Herz.

Corporate executives, however, see more to lose than gain from increased transparency. Intangible assets essentially represent the secrets of a business enterprise–the key resources and factors that enable it to compete effectively in the marketplace. If the company shares those secrets with investors (and with competitors), it could hasten the erosion of those very intangibles. Furthermore, the added transparency could open up a whole new avenue of attack for plaintiff’s lawyers. If corporate disclosures of intangible values prove wrong–and it is easy to be wrong about intangible values–shareholders will have plenty of ammunition for lawsuits. “We’re confusing people enough already with our disclosures,” says one senior financial executive of a Fortune 100 company. “This would only exacerbate the situation.”

INTO THE VACUUM

There is no denying the importance of intangible assets, however. Since 1980, the average ratio of market capitalization to book value for U.S. companies has swelled from just over 1 to more than 5–even after the recent swoon in stock prices. To be sure, differences in market and book value are rough estimates of the value of intangibles, points out NYU’s Lev. But, on average, intangible assets now represent about 80 percent of the market value of public companies. One possible explanation for the growth, of course, is that a whole lot of irrational exuberance has inflated corporate stock prices far beyond the value of the assets that the shares have claim to. The more likely explanation, however, is that financial statements prepared according to GAAP fail to reflect the true value of a company’s assets and operating performance.

In an increasingly competitive, knowledge-based economy, intangible assets, such as brand awareness, innovation, and employee productivity, have become the key determinants of corporate success. And given that the investments companies make to build those intangible assets–such things as advertising, employee training, and R&D–are flushed through the income statement, balance sheets are increasingly a poor reflection of the value of companies’ businesses. “The traditional accounting system is focused on transactions and historical costs,” says Sharon Oriel, director of intellectual asset management for Dow Chemical Co. “To determine the future value of a company, you don’t look at past history. You need new measures to project forward.”

This isn’t news to most companies, of course. In fact, a 1998 PricewaterhouseCoopers survey of corporate executives found that only 38 percent thought that their financial statements were very useful in communicating the value of their companies. In the high-tech industry, the figure was an alarmingly low 13 percent. Little wonder that executives are increasingly embracing alternative metrics that provide insight into such factors as speed to market and customer profitability to get a broader picture of their performance.

At Dow, the effort began five years ago, when Oriel helped take inventory of the patents, licenses, and technologies produced from the company’s R&D efforts. She then analyzed the research efforts in terms of whether they were oriented toward growth or merely toward value preservation. “We found that we were spending more on maintaining the status quo than on real growth opportunities,” she says. “By making that visible, we’ve now flipped [it] completely around.”

Oriel also credits an increased emphasis on intangibles with helping the company realize when it doesn’t have the necessary assets and capabilities to bring a promising product to market. Two years ago, for example, Dow invented a superior version of an elastomer, a rubberlike material used for gasketing. DuPont, however, had the leading product on the market, with a strong brand name behind it. “At the old Dow, we would have just brought the product to market,” says Oriel. “And five years later, we would have been saying, ‘Let’s cut our losses.'” Instead, Dow determined that despite having a superior technology, it lacked the other vital intangible assets to make the product profitable on its own. The solution? A joint venture. Dow and DuPont have been sharing the profits from their cooperative production of the material for the past five years.

Rockwell International faced a similar situation with a digital imaging technology it developed in 1995 called CMOS. Instead of spending potentially huge sums to enter new photography, office equipment, and medical imaging markets with the technology, Rockwell looked to develop relationships with companies already established in those industries. “There are times when you want to fight, and times when you want to partner,” says James O’Shaughnessy, chief intellectual property counsel at Rockwell. And such a decision usually depends on organizational flexibility, market position, and human resources. Corporate managers understand this, and their success depends on being able to evaluate those intangible factors.

INTANGIBLE BARRIERS

For the most part, shareholders are denied access to such evaluations by management. “Investors are aware that companies are valuing their intangibles, but they can’t get at [the information],” says consultant Herz. At least most of them can’t. Institutional investors with enough clout to get an audience with senior executives have been asking about R&D productivity, market penetration, and customer retention rates for years. But given the introduction of the SEC’s Fair Disclosure rule, even they may soon find that kind of information hard to come by.

The bigger roadblock to sharing information about intangibles, however, is the lack of workable reporting standards. The internal metrics currently used to evaluate intangible assets and capabilities are a long way from fitting the GAAP framework. How, for example, do you compare the customer loyalty of Microsoft software users with that of Wal-Mart shoppers? How do you compare the value of General Electric’s management training investments with those of Amazon.com? Intangible assets are soft and fuzzy, and for a profession that likes its assets hard and well defined, that’s a problem. “[Accounting for intangibles] introduces so much more uncertainty and judgment into the process,” says Bob Willens, an accounting expert at Lehman Brothers. “It may happen from a managerial point of view, but it will never be GAAP.”

Given concerns about the accuracy of reporting models for intangibles and fear of disclosing competitive information, there is certainly no groundswell among corporate executives to create such standards. Not only do they doubt the reliability of valuation methods for intangible assets, but they also fear the cost of the effort. “I’ve never been a fan of carrying intangible assets on the books,” says Joseph Bronson, CFO of Applied Materials, a $9.6 billion semiconductor equipment company based in Santa Clara, California. “They’re always going to be impaired.” Mercedes Johnson, CFO of $1.23 billion Lam Research, another semiconductor equipment company, based in Fremont, California, adds: “Accountants have a hard enough time evaluating assets already on the balance sheet. It would involve very subjective information and could lead to wide variations in reporting.”

She has a point. Consider again the new FASB proposal for goodwill. Currently, says FASB, the only intangible assets that can be separately recognized from goodwill are those in which “the future economic benefits of the asset are obtained through contractual or legal rights”- -namely, patents, licenses, and the like. Teasing out more intangibles from goodwill would involve some tricky judgments about how to allocate the premium paid over book value to individual intangibles. “We’d like to see it go that way, but it’s a question of getting the metrics to value them,” says Kim Petrone, project manager for FASB’s business combinations proposal.

The same difficulties apply to accounting for internally developed intangibles. In fact, attempting to isolate and value the intangible assets of companies may be counterproductive, according to the Brookings Institution task force, which was co-chaired by former SEC commissioner Steven Wallman. It concluded that the value of an intangible asset comes from its interplay with other assets–both physical and intangible–and that attempting to value it on a stand- alone basis is pointless. “Overall company value is driven by a host of interactive decisions and activities … and any attempt to disaggregate this overall value into individual intangibles would result in arbitrary measures,” the report said. For example, the value of a brand name depends on such variables as “product quality, price, distribution channels, dealer relationships, and other factors.” And the contribution of brand name to overall corporate value depends on how well management integrates it with other elements of the business. In other words, trying to value the Coca-Cola brand name apart from the other assets that contribute to and benefit from it is a meaningless exercise.

FOR WHAT IT’S WORTH

Part of the problem is confusion between the investments made to develop intangible assets and the value resulting from those investments, says Jeanne DiFrancesco, a principal at consulting firm ProOrbis, in Wilmington, Delaware. Take, for example, technology capital. DiFrancesco contends that contrary to some assertions, the asset in question isn’t the R&D efforts, but rather the fruits of those efforts. As a result, she says, capitalized R&D expenditures are not an accurate measure of a company’s technology capital. Likewise, investments made to train employees or to acquire new customers are poor indicators of other intangible values in an enterprise. “It’s not what it costs, but what it’s worth,” says DiFrancesco. “We have to shift the paradigm from costs to a sense of value.”

The Brookings study came to a similar conclusion. Despite corporate executives’ growing use of nonfinancial metrics in managing their businesses, most companies lack an adequate system for continually and accurately generating such information. The task force, after receiving feedback from preparers of financial statements, concluded that “internal efforts to track values of intangibles once the expenditures are made range from nonexistent to early stage.” And until those efforts progress, little information about intangible assets will be showing up in 10-K filings, let alone as line items in financial statements.

In fact, the number of companies even willing to discuss their intangible assets can be counted on one hand. And those that are, such as Dow Chemical and Rockwell International, do so largely because they believe they are undervalued by the market. “We’re a knowledge-based company,” says Dow’s Oriel, but it’s valued like a company based on bricks and mortar.

The so-called revelation principle–which suggests that once some companies reveal new information about themselves, the market will force others to follow suit–hasn’t kicked in here, either. The leaders of companies with the highest levels of intangible value–namely high- tech enterprises–have had little to gain from increasing their disclosures. At least until recently, Wall Street darlings like Microsoft and Cisco Systems were happy to let the market come to its own conclusions about their intangible value.

Moreover, corporate executives have no incentive to share the information they generate. Not only might they be held liable for errors, but sharing the information would further complicate investor relations as well. Shareholders are already crowding the kitchen when it comes to managing companies. If they had access to the inside information about intangible assets that managers have, it could only get worse. And given the inherent difficulty of accurately measuring intangible value, a new disclosure regime could be a Pandora’s box for corporate executives.

That hasn’t stopped the chorus of voices calling for a value-based accounting system. Baruch Lev, for example, argues that however difficult it might be to measure intangible values, it shouldn’t preclude companies from disclosing information about their efforts to build it. “Accounting doesn’t value anything anyway,” he says. “It simply informs about assets and investments.”

And the same treatment should apply to intangible assets, argues Lev. At a minimum, he says, companies should reveal what they spend on such items as employee training, customer acquisition efforts, and IT and Internet investments. In fact, he even believes that either the SEC or FASB should give corporations a push in that direction–not in the form of regulation, but by way of example. “If an authoritative body were to come up with a model of best practices,” he suggests, “it would pave the way for improved disclosure.”

If that comes to pass, accounting for intangible assets could become a very tangible new responsibility for corporate managers.

Andrew Osterland is a senior editor at CFO.

THE TERMS OF INTANGIBLES

THE FIRST STEP TOWARD managing intangible assets is to define the terms, says Jeanne DiFrancesco, a principal at ProOrbis, a Wilmington, Delaware, consulting firm. “We’re not able to define the assets,” says DiFrancesco. “Therefore, we can’t determine the value, either.”

DiFrancesco gets involved in the nitty-gritty of intangible asset management with clients. A large part of her job is to classify an operation’s assets–both tangible and intangible–in order to determine the returns they generate and the impact they have on corporate performance. To rationalize the process, DiFrancesco uses three “buckets”: physical capital, technology capital, and human capital. She then calculates returns on the three sources of capital, with the aim of optimizing a company’s mix of tangible and intangible assets.

James O’Shaughnessy, chief intellectual property counsel at Rockwell International, uses slightly different language. His buckets are organizational capital, intellectual capital, human capital, and a fourth category he calls complementary business assets, which includes such things as the leadership qualities of management as well as unique distribution and sales channels that help companies convert intangible capital to revenue. “There’s no point generating intangible assets if you can’t convert them to revenue,” says O’Shaughnessy.

For CFOs, just keeping track of the language is a major effort. The trick, says O’Shaughnessy, is to get executives to understand that value is a function of financial and intangible capital. “The more intangible capital you have,” he says, “the less financial capital you need.”

Simple enough in any language. — A.O.

GOODWILL REDUX

ON FEBRUARY14, the Financial Accounting Standards Board issued new accounting rules for business combinations. The pooling-of-interests method remains headed for the scrap heap when a final statement is issued, most likely in June. But, as a compromise, FASB radically altered the rules for the purchase method of accounting. Rather than amortizing goodwill to income, companies will now periodically review the asset for impairment.

The issues of how and when to conduct such reviews have given FASB fits since it took up the topic of business combinations accounting in August 1996. “The treatment for purchased goodwill has been the most challenging issue in our project,” conceded chairman Edmund Jenkins in a FASB press release last December. Nevertheless, the accounting standards body has finally proposed details.

The circumstances that will trigger impairment reviews of goodwill include, but are not limited to, cash-flow losses at reporting units carrying goodwill assets, adverse technology changes, increased competition, and loss of key customers or employees. The trigger could be a negative change in the legal or regulatory environment, a credit- rating downgrade, or even an “other than temporary” decline in the company’s stock price. In other words, any significant bad news could prompt the call for an impairment review.

Once a decision to review is reached–sure to be a new political football among regulators, auditors, and companies–there remains the tricky issue of how to determine the “fair value” of a reporting unit and its associated goodwill. FASB favors the use of market prices if transactions involving similar assets have recently been completed. But more often, firms will have to rely on valuation metrics such as discounted future cash flows, option pricing models, or fundamental analysis. The decisions about which method to use and how to apply it will be left up to companies, their auditors, and the SEC. “It’s going to be a very political process,” says Applied Materials CFO Joseph Bronson, “and a big source of revenue for the Big Five [accounting firms].” — A.O.